Ponzi scheme

Definition

A Ponzi scheme is a fraudulent investment scam that promises high returns with little risk to investors. It generates returns for older investors by acquiring new investors' funds rather than from profit earned by the operation of a legitimate business.

5 Must Know Facts For Your Next Test

1. Ponzi schemes rely on a continuous influx of new capital to provide returns to earlier investors, eventually collapsing when new investments dry up.
2. Named after Charles Ponzi, who orchestrated such a scam in the early 20th century involving international postal reply coupons.
3. Ponzi schemes are illegal and are considered forms of securities fraud.
4. Corporate governance mechanisms may fail to detect Ponzi schemes if oversight and transparency are lacking.
5. Notable examples include Bernie Madoff's multi-billion dollar fraud, one of the largest and most infamous Ponzi schemes in history.

Review Questions

• What is the primary mechanism through which a Ponzi scheme generates returns for its investors?
• Why are strong corporate governance practices important in preventing Ponzi schemes?
• Who was Charles Ponzi, and what did he do that led to the naming of this type of scheme?

Related terms

Securities Fraud: Illegal activities involving deception to manipulate or misrepresent information about securities.

Pyramid Scheme: A scam similar to a Ponzi scheme but involves recruiting additional participants at multiple levels.

Due Diligence: The investigation or exercise of care that a reasonable business or person is normally expected to take before entering into an agreement or contract with another party.